Emergency Fund vs. Retirement: Which is More Important?

We’ve read about your plan, and we’re in pretty good shape financially, but we don’t know what to do next. We have $400,000 in a 401(k) for retirement, but we don’t have an emergency fund or any other savings. The only debt we have is our house. What should we do about Baby Steps 4 and 6?

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-Mary

Dear Mary,

You guys have done a great job of saving for retirement and staying out of debt. Let’s go over the Baby Steps you mentioned. Baby Step 4 is putting 15% of your income into Roth IRAs and pre-tax retirement plans. Baby Step 6 is paying off your home early.

The thing that worries me is you’ve completely skipped Baby Step 3, which is having three to six months of expenses in an emergency fund. This is money set aside strictly for emergencies, not vacations, toys or a new car. The problem right now is if you have a real emergency, you’ll have to cash out your 401(k). If you do that, the government’s going to penalize you 10%, plus your tax rate. That’s about a 40% kick in the teeth just because you didn’t do things in the right order!

Again, you’re in pretty good shape overall, but in building your financial house you’ve put the roof on before you’ve laid the foundation. If I’m you, I’m going to temporarily stop my 401(k) contributions until I get my emergency fund fully loaded. By temporarily, I mean six months at most. That way, you’ll be covered when life happens without having to sacrifice your retirement savings!

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-Dave

Dear Dave,

My daughter is a student and has $13,000 in student loan debt. Recently, her grandparents dissolved an LLC, and they want to give her a gift of $12,500. Should she use this money to pay off the loans, or invest it in a Roth IRA and keep working to pay off the student loans herself?

-Meg

Dear Meg,

Let’s look at it this way. Pretend she didn’t have any student loan debt. Would it be wise for her to borrow money on a student loan in order to invest in a Roth IRA? Of course not. If you don’t pay off the loans, and invest it instead, it’s just like you borrowed money to invest. That’s not a good plan.

Your daughter needs to get her student loan mess cleaned up, and this is the perfect opportunity to do just that. And I think it’s pretty cool that God gave her what she needs to fix things. Besides, she can’t do a Roth IRA, except to the point that she has an earned income, anyway.

The last thing this girl needs is a pile of debt waiting on her when she gets out of school. She’s not in a position to be an investor right now. The minute she pays off her student loans, she should get to work on saving a pile of money for an emergency fund so she can complete her studies without racking up more debt!